For something that cannot be directly observed, and changes through time, the neutral level of interest rates generates an awful lot of debate, says Strategist Russell Silberston.
25 Jan 2023
25 January 2023, Asset markets and investors experienced a tough year in 2022. Both global equities and bonds declined sharply, resulting in a passive 60/40 global equity/bond portfolio returning -18.1% in US dollars and having its worst year since 2008. The culprits were a combination of stretched starting valuations, major central banks moving to fight inflation and recessionary conditions in China. So, what will 2023 hold?
This year, the developed world will likely suffer the consequences of last year’s tightening, as the lagged effects feed through into growth and earnings and we see the full impact of central bank policy tightening. This is beginning to be seen in money supply growth, which for many developed market economies is set to turn negative this year. We also don’t anticipate a change in central bank policy until notable weakness in the economy has materialised - likely a precondition to sufficiently weaken the labour market and lower underlying inflation pressures. As a result, we see a higher likelihood of a recession.
How will asset prices respond? Last month we discussed the potential upside case in Chinese equities given the positive inflection in the Chinese regulatory cycle and favourable dynamics in the Chinese credit cycle. The situation could not be more different for DM equities, where recession risk is growing by the day and yet to be priced. As everyone knows, last year’s sell-off was a function of multiple deratings as interest rates and bond yields rose, but there has yet to be much in the way of downward revisions in earnings. During a recession, earnings usually experience a 15-20%-plus decline.
By contrast, developed market government bonds, which have been one of the biggest victims of this rapid tightening in central bank policy, could also be a significant beneficiary of a recessionary environment, particularly if, as we expect, this leads to a peak in the inflationary backdrop in 2023. Valuations are also increasingly attractive, for example, real interest rates – a measure of value – are the highest they have been in 12 years. We see the best opportunities in high-grade government bonds in countries where housing markets and households are already feeling the effects of current hiking cycles. These nations include South Korea, Canada, Australia, New Zealand, and Sweden.
One central bank to buck the tightening trend has been the Bank of Japan (BoJ). Japan has not experienced the same degree of inflation, which means the BoJ has uniquely pursued easing while all other developed market central banks have been tightening. The BoJ’s policy of ‘Yield Curve Control’ involved printing unlimited amounts to cap the level of interest rates on 10Y Japanese government debt. This divergence in policy has led to significant weakness in the Japanese Yen and despite one of the worst years on record for global assets the currency lost 14% vs US dollar and 7% vs the Euro in 2022.
However, in our view, a change in Japanese policy is becoming highly likely. Japan has pursued ultra-dovish policy because of a longstanding policy consensus to end deflation. Yet progress has been made on inflation and wage expectations are approaching a level not seen since the early 1990s. Meanwhile the BoJ has also noted that the costs of easy policy may be outweighing the benefits due to the impact on domestic bond market functioning. This is occurring in the context of impending institutional change at the BoJ as the next two candidates for Governor have more hawkish views than current Governor Kuroda. All of this is likely to lead to a turn and place significant upward pressure on the yen in 2023, especially since a change in BoJ policy will be occurring against the backdrop of other developed market economies entering a recession.